If nothing else, it has been fun to watch "economic value added" spread like
the latest elixir. Stern Stewart, a New York consulting firm, trademarked EVA
as a tool for measuring business performance. In recent years, the firm has
been increasingly successful, like some, though not all, of its clients -- and
far from shy about talking up its success. EVA has become a buzzword: You can
almost hear the just-converted chief executive confide to his peer, "We're going
on EVA." And the listener will nod, and will detect that his rival is joined
to the great crusade for shareholder wealth, and will probably make a mental
note to get with the program himself. Among those already there: Coca-Cola Co.,
Eli Lilly & Co., Quaker Oats Co. and AT&T Corp. Lately, EVA has made a further
advance -- into the realm of investing. After all, if it can help managers better
allocate their companies' capital -- and it seems to have helped some -- why
shouldn't it help you, the investor, allocate yours? Growing Usage No less than
Fortune magazine dubbed it, in the title of an article, "A New Way to Find Bargains."
Recall that old investment yardstick, earnings per share? It's losing ground
to EVA, the magazine gushed. Though that is pushing it, research analysts at
Credit Suisse First Boston Corp. now include EVA along with earnings, sales,
cash flow, return on equity and accumulated frequent-flier miles as investment
tools. Michael Mauboussin, the investment bank's EVA maven, has lectured investors
in Hong Kong, London, Frankfurt, New York and even Buffalo, N.Y., to rapturous
receptions. Goldman, Sachs & Co. is on board, too. The intriguing idea behind
EVA is to express in a single number two concepts: net profit and rate of return.
EVA equals a company's profit less what it would have earned with an "expected"
return on capital. If a company's target is 10%, you expect $100 on $1,000 of
capital. If it in fact earns $120, it has added $20 of EVA. Stern Stewart has
protected its turf in part by tinkering with definitions of profit, in ways
that are by turns sensible and dubious. (It regards, for example, Coca-Cola's
advertising not as an expense but as an "investment." I could quibble, but either
way Coke will earn a lot of money and a lot of EVA.) But its main point is that
only the profit above the expected hurdle rate "counts." New Wine? There is
everything sensible and nothing new in the idea that capital has an implicit
cost -- an opportunity cost -- and that it is the return on capital that matters.
You would rather deploy $1 million in a project likely to earn 20% than invest
a larger sum and make 6%. But total profit also counts. So if you could invest
a lot more and still expect, say, 18%, you would do it. If companies hire Stern
Stewart to rebottle this old wine, no one is much the worse. And if that's what
it takes to get certain managers thinking about rates of return, and to design
incentives so that employees will do the same, so be it. Joel Stern, a partner
in the firm, a former student of Milton Friedman and a devotee of Chicago-school
economics, makes rather a grander case. "EVA gives you the hurdle rate," he
says, whereas heathens outside his tent "don't have a method for capturing it
in a single number." Simple Concept Perhaps that is because no one number can
do it. Stern Stewart's formula is based on the capital-asset pricing model,
an academic theory according to which the stock market is a perfect machine
that predicts -- in the form of price volatility -- the exact hurdle rate for
every stock beneath the heavens. A stock that in the past was twice as volatile
as the average supposedly proffers twice as much added return over Treasury
bills. Unfortunately, academics have shot the theory full of holes. Jay Ritter,
a University of Florida professor who keeps up with such matters, says, "The
theory is compelling, the evidence is abysmal." (Query for First Boston and
Goldman: If they are touting a formula that assumes an efficient market -- meaning
stock prices are ever right and the market ever unbeatable -- why not fire their
analysts and be done with it?) But without EVA, what hurdle would one use? In
the words of Jack Ciesielski, publisher of the Analyst's Accounting Observer,
"the cost of capital is one of the unsolved riddles of finance." Debt costs
whatever interest rate you pay, but what does equity cost -- or rather, what
return on it is required? One must rely on judgment and horse sense. A chief
executive officer should certainly strive to beat the average return in his
industry. But over time, he should be thinking about whether his industry is
sufficiently profitable -- and if it isn't, redeploying capital elsewhere, or
letting shareholders do it for him. This may be imprecise, but it conforms to
decisions in the real world. When Coke entered China, it wasn't because a sign
on the Great Wall said, "Thirty Percent on Capital." Rather, Coca-Cola knew
its return in emerging markets was much higher than what shareholders could
expect in most other businesses. And that was enough. I am all for the right
incentives, and it is nice that Coca-Cola pays cash bonuses on profits above
a hurdle rate. It is also irrelevant -- because Coke, like some others who talk
the talk, awards immense stock options with no hurdle rate. In 1995, Coca-Cola
Chairman Roberto Goizueta got options on one million shares at the market price.
If the stock rises 5% a year, he makes $36 million; at 10% a year (still less
than Coke's 11% hurdle rate), $91 million. As for using EVA as an investment
tool, it's a good idea -- if you can't divide. Warren Buffett remarked of EVA
at his company's 1995 annual meeting: "I don't think it's a very complicated
subject... . I didn't need [it] to know that Coca-Cola has added a lot of value."